After the tech incubator bubble

This article was taken from the June 2012 issue of Wired
magazine. Be the first to read Wired's articles in print before
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Back in February 2009, Kristian Hiiemaa, then 29,
bootstrapped Erply, a
business-software startup, with three other developers in Tallinn,
Estonia. They applied to Seedcamp, the London-based
mentoring and investment programme, and were selected for Seedcamp
Week -- in which startups are mentored -- the following September.
There, they dazzled investors at the pitching stage, known as Demo
Day.

A tour of the US with other Seedcamp
winners to meet investors and advisers ensued, and Hiiemaa's life
changed. "Between the Monday and the Friday [of the US trip], Kris
had two or three unsolicited term sheets to invest from tier-one
Silicon Valley VC firms," recalls Saul Klein, Seedcamp's founder
and a partner at Index Ventures. "He spent the next week or two in
Tallinn fielding Skype calls from 20 VCs, including an investor in
Microsoft."

In March 2010, less than a year
after launch, Erply announced that it had closed a $2 million
(£1.25m) funding round, led by Redpoint Ventures and Klein's
Index. A year after that, they'd opened an office in New York and
signed up clients including Elizabeth Arden, which now uses Erply's
retailing platform across its chain. "From a snowbound Estonian
office with 60s furniture to Elizabeth Arden on
Fifth Avenue [in Manhattan]," says Klein. "It's like a fairy
tale."

Erply's story demonstrates exactly
what Seedcamp was set up to do, Klein says. "The core of this
movement is to help talent and pull them in from the 'extremes', in
remote locations like Estonia, or fragmented ecosystems, like
Europe's, and get them from 0 to 60 in terms of advice and
connections."

Since Seedcamp launched in 2006, a
proliferation of accelerators has transformed the landscape for
tech startups seeking early-stage investment in Europe. From Yandex Factory in Moscow to Dad.es in Madrid, Gamma Rebels in Warsaw,
Copenhagen's roving Startupbootcamp, White Bear Yard in London and
Birmingham's Oxygen
Accelerator, Europe is now home to at least 50 programmes vying
for entrepreneurs, with many pitching their own spins (shared
office space, government cash, virtual incubation, intensive boot
camps) on hot-housing the next coding entrepreneurs.

Inspired by the success of US programmes such as Y Combinator (Wired 07.11),
founded in Silicon Valley in 2005, and Techstars, launched in 2006 in
Boulder, Colorado, incubators are increasingly central to the tech
ecosystem, because they sift thousands of companies in their
selection each year (Seedcamp gets 3,000 applicants). This helps
later investors find the right startups to back.

But is Europe producing the talent
to meet the expectations of so many investors? Or could we be in a
bubble where too many second-rate businesses are being nurtured? "I
do think there's a surge," says Reshma Sohoni, a partner at
Seedcamp. "And not only is the quality of the startups in question,
but also the quality and experience of the folks running them."
Sohoni predicts the market will correct in the next few
years.

The most effective programmes,
argues Michael Jackson of Mangrove Capital Partners (a
$500 million fund), are those that act as "a great filter".
"Mentors throw projects up to us, but we're probably only going to
take one of them," he says. "And they can't give us 198 pieces of
junk, because we won't take their calls any
more."

In its six years of existence, Mountain View-based Y
Combinator (YC) has welcomed 316 startups. The pioneering fund
designed a new way to back startups by investing an average of
$18,000 twice a year (considered "living expenses") in lots of
companies (around 60 in summer 2011) and inviting them to Silicon
Valley for three months of intensive mentoring and project
refining. For its investment, YC takes a stake of around six to
seven per cent in each company. The process culminates in a
nail-chewing Demo Day of pitching in front of power-broker
financiers with billions at their disposal.

YC alumni consider the value of the
programme to be twofold: the practical advice about fundraising,
and the network of mentors -- which remains long after the startups
disperse. "We were three tech guys who'd started companies
successfully in the past, but had never raised funds before," says
Allan Grant of social-marketing platform Curebit, part of YC's winter
2011 intake. "So learning how to fundraise helped us a
lot."

For Ian Hogarth, cofounder of
London-based Songkick [Wired 05.12], who attended the programme in
summer 2007, it was the contacts book and instant induction to a
tech elite that helped. "The alumni network has been hugely
beneficial, and to this day we continue to receive advice and
support from the YC partners," he says. "We are still close to many
people from our batch of entrepreneurs, including Daniel Ha from Disqus, Sachin [Rekhi] from
Anywhere.fm and Drew [Houston] and Arash [Ferdowsi] from Dropbox.
We've met more YC founders each year, as new folks go through
it."

In November 2010 two investors, Ron
Conway and Yuri Milner, offered $150,000 to every startup in the
programme, ensuring that each business in that batch raised further
cash after attending YC. So, as the programme's cofounder Paul
Graham noted in Wired 07.11, a better gauge of YC's hit rate is to
measure how many of the summer 2010 cycle -- 36 startups -- managed
to raise more money after the process. "Of those, 33 raised more
money after YC, one didn't bother because they were already
profitable, and two were not able to," he noted on the YC website.
"So 34/36 or 94.4 per cent either raised money or didn't need
to."

Graham went on to say that, although
funding was simple to gauge, it wasn't "the real test". He
observed: "What matters is how the companies end up doing. The
standard test of that is its value." By the summer of 2010, YC had
funded 208 startups. By looking at "the acquisition prices of the
companies that have been acquired and trying to estimate the values
of the rest", Graham calculated that the mean value of the startups
funded by YC up to that point was $22.4 million. He conceded that
startup valuations are "volatile" and that "six years in, all we
can say is the numbers look encouraging".

YC has had three breakout hits: file-hosting service
Dropbox, valued at $4 billion at its last $250-million funding
round; accommodation rentals network Airbnb, valued at $1.3
billion; and Heroku, a cloud
application platform, which was acquired in 2010 for $212 million
by Salesforce.com.
The trio combined are worth about $6.5 billion. This, argues Tom
Hulme, design director of IDEO with close links to another
accelerator, HackFwd, means that
YC and other accelerators have rebooted the early-stage investment
model. "This shows that the investment game is about not missing
out on the big wins, rather than screening out losers. This is
affecting valuations, so smart investors, such as Yuri Milner, are
willing to pay more to ensure they're not missing out on hot deals.
For the accelerators it's a reminder that it's a numbers game --
they need to cast the net wide to catch the rare big fish."

But Reddit cofounder Alexis Ohanian, a YC alumnus
who's now an "East Coast ambassador" for the programme, sees
nothing wrong with this policy, as it tilts power away from
institutional investors in favour of startups, creating far more
viable companies. "There is clearly a desire to hit huge home
runs," he says. "But what's nice about the YC model is that it also
succeeds when you have smaller exits. All of these VC firms, which
were based around the idea that founders needed to beg for money,
are now in this awkward position where YC and others have built a
model that doesn't need tonnes of money to be dumped in, with the
hope they'll get the home runs to make up for the failures. YC's
model means they invest around $20,000 a startup, and the goal is
to create lots of great companies."

Last November, Birmingham-based accelerator Oxygen
held its inaugural investor demo day at Birmingham Science Park
Aston. Nine startups pitched their business ideas to an audience of
about 100, among them potential investors. Although at times it
felt more like a regional sales conference than the nerve-fraying
hell described by those who have attended demo days at the leading
US programmes, there was much at stake for the fresh-faced
entrepreneurs -- including a £75,000 cash prize, with no equity
strings attached.

Those who claim there is a bubble in
the European incubator/accelerator space have unproven schemes such
as Oxygen in mind. So, four months on, what had Oxygen's hopeful's
achieved? Cofounder Mark Hales, an entrepreneur who is also a
founding investor in the Cambridge accelerator Springboard, told
Wired that "five of the teams have raised or are in the final
stages of raising" the investment they were seeking -- which varied
between £100,000 and £200,000.